Wednesday, February 28, 2007

The Bigger Story?

A bigger story than what's happening in the stock market this week may be what's happening in the world's bond markets. We may have finally hit a turning point in investors' appetite for risk. From Bloomberg:

Bond Risk Soars by Record in Europe, Credit-Default Swaps Show

Feb. 28 (Bloomberg) -- The risk of European corporate bonds from carmaker Fiat SpA to music producer EMI Group Plc surged by a record, fanning a global market rout, according to traders of credit-default swaps.

...Investors are concerned rising delinquencies on the riskiest mortgages in the U.S. may spread to other parts of the home-loan market, hurting consumer confidence. Bank of America Corp. yesterday recommended investors sell corporate bonds as "housing-led weakness" spreads to the broader debt market.

As the following chart shows, investors have been willing to accept an increasingly small risk premium (which I've measured here as the difference between the interest rate on US corporate bonds of varying quality compared to the interest rate on US government bonds) over the past few years. But those risk premia have now reached a level that is historically about as small as we've seen, at least in recent history.

(Click on image for better view. Btw - I'm pretty grumpy that blogger has started messing with my images...)

The risk premium generally follows the business cycle (as Spencer pointed out in the comments yesterday). It may be the case that we've now hit bottom, and we may eventually remember this week as the week that risk premia started rising again.

Contact

The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)